The non-dilutive financing world has exploded for startups. A once taboo word in startup culture has since become a cornerstone in the private markets. Lending platforms, private credit funds, and Family Offices alike have found a friendly and profitable home lending to growing tech startups.

As the once boiling equity markets continue to simmer, more startups have looked towards alternate methods of financing to keep operating capital nearby until the appetite for equity rounds rise. In our previous posts, we’ve discussed what debt financing is including its benefits and drawbacks. Here we will cover what these products and structures actually look like, how to evaluate newer and unconventional loans, and what debt on your balance sheet means for future VC fundraises.

At Diadem Capital, the majority of companies we see securing debt financing, specifically Venture Debt, have raised at least Seed capital. This is not to say that lenders only lend to Seed-stage businesses or startups with an equity sponsor, but post-Seed companies tend to generate the revenue required for lenders to properly underwrite the business. For this reason, the post is geared towards revenue generating startups, particularly post-Seed.

Evaluating the top debt financing options

When a company raises Seed capital the odds are it will be a long, arduous process. What many have deemed as a “tough fundraising environment” may simply be the new norm for the foreseeable future in the VC market. Investors have placed extra emphasis on diligence and need time to dig deep into the market, conduct customer diligence, look at the founding team’s relationship diagrams and more. The good news for founders is that the debt markets are somewhat less stringent. Diligence requests can still be hefty but between underwriting a company and its ability to pay down debt versus its ability to reach a $1B valuation – guess which one is easier.

As a founder, you know your business better than anyone. It’s important that you develop a clear and honest view of your revenue, customer mix, and financial model in advance of speaking with lenders. For example, there are plenty of pure B2B SaaS lenders. If you’re not a true software company, this avenue isn’t for you. Additionally, if you have a software product where 80% of revenue is B2C, as opposed to B2B, don’t be surprised when a B2B SaaS lender passes. The nice thing about lenders is that unlike some equity investors that operate on a “I’ll know it when I see it basis” lenders are in the business of telling you exactly what they want, plain and simple.

As a founder, it’s difficult to understand not only what your options are, but also what’s best for your business. Debt can be confusing, that’s why we always like to have a thorough understanding of a founder’s business to help them identify the handful of avenues that make the most sense.

For example, if you’re an asset or inventory-heavy business, then asset-based loans make sense for you. Maybe you’ve grown an outstanding e-commerce brand. There are numerous, excellent CPG platform lenders specifically catering to expanding brands. We can go on and on with possible examples of debt funding opportunities but our advice to get you started in the right direction is answer the following three questions:

1. Who are my customers?
2. What type of revenue does my business generate (e.g. transaction, subscription, recurring, reoccurring)?
3.  What assets does my business have (e.g. PPE, Accounts Receivable, Inventory, Purchase Orders)

This is a simple exercise that exposes where lending opportunities lie in your business. A most important piece to addressing non-dilutive capital is to fully understand the credit product you are evaluating. Notes, SAFEs, and priced equity are typically straightforward but this is not always the case for non-dilutive capital.

Best scenarios for opting for debt over equity

Perhaps the largest question founders face is determining, “when is it the right time to pursue debt rather than equity?” After all, debt is a naughty word, right? Should you pursue it all? Well, it’s bad to over-lever a business but when used correctly, debt is an excellent tool to inject cash into a business with minimal dilution. There are a handful of scenarios we will examine that explain where non-dilutive capital is or is not the best path forward.

1. Avoiding further dilution: For some founders with healthy companies, the roadmap is clear. The way forward is calculated and the execution is clinical. You know exactly how to get there and how much capital you need to do so. If an exit or liquidity event is imminent, securing non-dilutive capital pads your balance sheet while enabling you to maintain maximum ownership of the business. As a venture business, you’ve raised your Pre-Seed and we can say conservatively you diluted yourself 12-15%. After closing a Seed round, you’ve diluted another 20-25%. Then include the additional $3-4 in convertible notes you raised from previous investors in the interim. In this scenario, prior to even beginning your Series A, you’re diluted 40%+. This is a large reason why non-dilutive capital is attractive to experienced founders.
2. Invest in sales and marketing: The best place to direct non-dilutive dollars is towards the parts of the business that pay you back. Within sales and marketing, you can clearly and accurately account for spend and ROI.
3. Project-based revenue: Debt can be strategically applied to the project-based components of your business. Debt payments can be aligned with milestones in your project and lower the overall cost of capital. The more advanced term for this approach, often used in municipal projects, is project finance. It plays a smaller role in the startup community.
4. Avoid putting equity dollars towards fixed-assets: If you sell a physical product, VCs would much rather see their dollars go towards headcount or technology as opposed to purchasing materials or machinery. This is an excellent spot for a line-of-credit that funds inventory or a sale-leaseback for equipment financing to limit your cash burn for as long as possible and pay down as you go.

Startups: Traditional vs. Unconventional debt sources

The age-old image of getting a loan by walking into a bank, sitting down with a banker and underwriter, walking through your business, and hearing a qualifying offer actually still exists – just primarily online. Tech lending is plentiful and lending platforms have played a major role in that expansion. Depending upon your familiarity with tech lenders, you might be surprised to learn that for some, your Excel financial model means very little in the actual underwriting of the business.

Lending platforms, many of which consider themselves Fintechs rather than traditional lenders, have unique and often proprietary methods for underwriting companies and issuing credit products. Most commonly, these processes include granting the Fintech lender access to your accounting software (e.g. Quickbooks) or bank accounts via API.

After receiving access to the necessary data, the FinTech lender’s underwriting tech evaluates the financial health of your startup through direct data connection. This provides clear insight into pay periods, cashflow, and expenses in a much more seamless way as opposed to sifting through clunky models. This alternative approach is typically fast with initial terms or offers delivered in a couple days or even a couple hours. This model is most popular with B2B SaaS and e-Commerce businesses/platforms with predictable cash flows.

Another unconventional method for debt financing, often unfamiliar to founders, is data-based landing. Regardless of industry, founders wonder if there is a way to monetize their data collection. After all, new businesses often find themselves directly or incidentally capturing valuable customer data as a business grows, launches new products, or redirects.

The key question is, “What do you actually do with the data? How do you turn a data lake into accessible capital?”. Whether you host on AWS, Snowflake, or Google Cloud, there are advanced lenders that have done the hard work for you in understanding how to extract that value from that data. Lending based upon data assets is not necessarily a novel approach, but the rate at which this process can be completed and the extent to which data is valued has increased dramatically.

Since data is classified as an intangible asset, it takes a specialty data-based lender to help you understand exactly what your data value and restrictions look like. There are a handful of approaches in data-based lending including straight data valuation, data lending using your data as collateral, or working with a data-based lender who has experience building monetization channels with clients. 

To reiterate this point, it’s okay to ask questions as a founder. With the number of new Fintech lenders entering the market every day, you’d be foolish if you didn’t dig into these new products and build confidence in understanding how they differ.

Aligning your debt strategy with venture capital goals

If you’re a founder considering raising debt then you’ve probably wondered what that  means for future conversations with VCs. You’re right to do so. If your ultimate goal includes additional venture fundraising, then your debt strategy must be crafted carefully. Here are a few things to consider:

Bad

Debt is not a substitute for an equity round: from the VC perspective, the concept of debt and non-dilutive capital is that it should be used to achieve a specific goal or complement a portion of your business. Validation and reinvestment from your prior equity investors is a key positive signal for Series A investors, so using debt as a substitute for that equity can impede your ability to raise equity later on.

Let’s say your business is looking for a small credit facility but has the opportunity to take down a larger facility and initial draw that theoretically enables you to skip an equity round altogether. On the surface, that sounds great and for some founders it is great. The source of the capital may not make a difference for them; but, it’s important to keep in mind that forgoing new equity partners can open you up to questions from VCs when it comes time to raise again. This can signal investors were too skeptical to get involved and debt was a last resort. Again, that’s not always the case, but for venture investors, it’s troublesome if a founder explains that they elected debt as a full substitute for an equity round.

Over-levering the business: this goes hand in hand with the point above. Taking on too much debt simply because it’s offered is a recipe for disaster. It’s nice to be flushed with cash as a startup, but those dollars need to be put towards growth and not sitting in a treasury account with no plan. Too much debt sends signals of mismanagement and poor planning.

Good

Improving cash flow: one of the key evolutions from the VC correction post-2021 has been the re-focus to fundamentals. This means margins, burn, and cash flow. Utilizing non-dilutive capital to increase working capital is a great and healthy usage of debt. Mitigating cash crunches and ensuring positive cash flow is a positive signal for VCs.

Extending runway: non-dilutive capital is an excellent tool for extending runway, especially on the heels of an equity raise. It pads the balance sheet and provides additional optionality and flexibility to founders for subsequent raises.

Removing high cost debt: it’s not abnormal for founders to find themselves in a squeeze, especially in tough fundraising environments. The end result is often short-term, expensive debt. While this isn’t always a deal breaker for VC investors, don’t expect them to stay on the phone for long if you begin to explain that 30% of this equity round is going towards paying off an expensive line of credit. Some lenders prefer that their capital be put towards growth so it’s important to identify the right lenders comfortable and capable to execute a refi or debt take down.

Importance of creditworthiness for post-seed startups

As we’ve covered, lenders vary widely in their terms, structures, and approach. While many look exclusively at the efficacy of a company and its financial health, the creditworthiness of a business may not always be tied only to the business entity. Riskier debt capital may come with what is called a ‘personal guarantee’.

With this stipulation, the founder or another financial backer must promise personal repayment for the debt. Diadem Capital works with over 100+ different lenders, none of whom require personal guarantees. We still make sure founders have a clear understanding of the fine print that comes with any debt term sheet, whether it comes from our network or not.

Mitigating risks when leveraging debt for growth

Risk mitigation for debt capital is an ongoing practice. It does not end when you accept a term sheet or begin making principal payments. A key facet to risk mitigation actually begins at the forefront of term sheet negotiation – primarily, ensuring that you as the founder have a perfect understanding of any covenants, triggers, conditions, warrants, auditing rights, and more.

The area of a term sheet that often requires the most time, attention, and explanation is the covenant section. Covenants are restrictions or rules that require a company to operate within certain parameters for the duration of the loan and most often come in the form of financial restrictions. A common example is an increase or decrease in floating interest rate depending upon the revenue milestones a company achieves within a certain time period. This is where the risk mitigation comes in. Founders must anticipate changes in payment according to their company’s growth.

Failing to hit milestones can trigger additional payments and penalties if the lender so chooses. The right lender will want to grow with you as a business and help you through down-revenue periods – the structure they propose usually speaks to that. For example, many venture debt lenders will correlate interest payments with revenue momentum so that when revenue is light, so are interest payments. When revenue is up and you can comfortably make payments, the size of the interest payment will increase accordingly. 

Another common covenant is that a senior lender must approve any new indebtedness taken on by the company. If a lender fears for the financial stability of a company due to over-leverage, they can deny the founder’s ability to accept any additional non-dilutive financing. This can be limiting for founders looking to incorporate a new source of non-dilutive capital into the business.

Raising debt capital as a post Seed startup can be a scary process. Diadem works with founders to help them understand their options, term sheets, and close with confidence. Diadem Capital is a fundraising marketplace for Venture-backed companies. With Diadem, founders quickly increase their top-of-funnel conversations and have the door opened to Family Office, traditional VC, Corporate Venture, and debt and non-dilutive relationships that otherwise would take months to develop.

With a success-based fee, founders pay nothing unless they actually secure capital. That’s how it should be, right? No funding – no fee. We talk live with every investor before sending dealflow to understand their criteria well beyond stage, sector, and geography. Diadem is building the largest warm introduction network for Venture in the world. Sound interesting? Let’s chat.